UBS: 1000% Inflation Is Perfectly Acceptable...

One of the biggest fears in the economy is that inflation gets
out of control and morphs into
hyperinflation.

But as with anything in the markets and the economy, expectations
are key.

In a recent note to clients, UBS Chief
Economist Larry Hatheway suggests that even 1000 percent
inflation can be manageable as long as people see it coming.

From his recent Macro Keys note:

When 1000% inflation can be desirable In fact,
the costs associated with inflation (price change) are less than
commonly supposed. There is the famous “sticker price cost” – the
cost of constantly changing price labels – but in a world of
electronic displays and web based ordering this is not a serious
economic cost (in fact, it never was). To take an extreme
position, one can make the economic argument that there are only
limited costs in having inflation running at 1000% per year, with
one caveat. 1000% inflation is perfectly acceptable, as long as
the 1000% inflation rate is stable at 1000%, and it is
anticipated. Of course, one can argue that high inflation tends
to be associated with high inflation volatility and uncertainty
(and that is true empirically), but economically it is the
volatility and uncertainty that does most of the damage.

The maximum damage from inflation comes if it is
unexpected or if it is unpredictable. Unexpected
inflation causes damage, because the investor who holds bonds
yielding 1% for a decade is going to feel cheated if inflation
turns out to be 1000%. Of course, no one would voluntarily buy 1%
yielding bonds if 1000% inflation was expected. Thaler’s Law
comes into operation here; people dislike losing money more than
they like making money. As a result episodes of unexpected
inflation will lead to a significant adverse reaction on the part
of consumers.

Unpredictable inflation is damaging because it
causes uncertainty over an investment time horizon – and that
uncertainty is a risk that will demand a compensating premium.
What the inflation uncertainty risk does is raise the real cost
of capital. If I think inflation will be 3% but I am not sure
whether it will be 3%, 0%, or 6%, I am likely to demand
compensation for the 3% inflation risk but then additional
compensation for the possibility that the inflation risk is as
high as 6%. The additional compensation is an addition to the
real cost of capital.